A great example. In fact, two great examples!

Think of a 2 for 1 split !!! That makes twice as many shares, but it doesn’t make any difference to the company. NO ONE WOULD DREAM IT REDUCED THE COMPANY’S NET INCOME! It dilutes the income per share! You, as a shareholder, don’t mind because they gave you enough new shares so that even though you only make half as much per share, your percent of the whole is the same.

But if they did a 2 for 1 split and gave the other half of the shares to the CEO instead of the old shareholders, you’d be rightly pissed, because they gave away half your ownership in the company, but IT STILL DOEST REDUCE THE COMPANY’S NET INCOME. The company doesn’t care where those shares went. Shares are shares to the company. To say that it reduces the company’s Net Income is laughable. It’s nonsense.

Now let’s think of an 11 for 10 split (they happen). The company gives you 1 extra share for every 10 shares you have (sometimes called a stock dividend, but it’s the same thing). It cuts the earnings assigned to each share, **but it doesn’t make any difference to the company.**The company doesn’t care how many shares it has (witness the 2 for 1 split above). NO ONE WOULD DREAM IT REDUCED THE COMPANY’S NET INCOME!

Now let’s say they did that same 11 for 10 split and instead of giving those shares to the old stockholders they gave those new shares to someone else who is not an old stockholder. It still doesn’t make any difference to the company. The company doesn’t care how many shares it has (witness the 2 for 1 split above). NO ONE WOULD DREAM IT REDUCED THE COMPANY’S NET INCOME!

And say that “other person” they gave the extra shares to happens to be an officer of the company. It still wouldn’t make any difference to the company. The company doesn’t care how many shares it has (witness the 2 for 1 split above). NO ONE WOULD DREAM IT REDUCED THE COMPANY’S NET INCOME!

Except GAAP, which suddenly now thinks Net Income is reduced. It’s pernicious nonsense!

Best,

Saul

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Hmmmm.
I might have to respectfully disagree. If the shares are given to an officer, it is reasonable to consider it part of their income package. That is, it is a real ‘salary’ cost to the company (and to other shareholders) that should be considered when calculating net income. Actually, one of the things I have always disliked about shares given to officers is that it seems to be a way to pay them ‘sneakily’, i.e., without accounting for a cost to the company, despite it being very much a cost.
-lemur

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That’s true, but the effect on the shareholders is the same. Whether we, as shareholders, pay the CEO through dilution of our ownership or through cash held by the company, it’s still affecting our share of the earnings.

As investors, shouldn’t our primary concern be our share of the earnings?

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despite it being very much a cost.

Except that the cost is to the shareholders, not the company. Zero dollars came out of the company to make that award. This is one of the reasons that startups often have compensation packages which are heavily weighted to stock rather than salary. Not only does this motivate employees to make the company succeed, but it dramatically reduces the amount of cash out flow from the limited start up funds.

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I might have to respectfully disagree. If the shares are given to an officer, it is reasonable to consider it part of their income package. That is, it is a real ‘salary’ cost to the company (and to other shareholders) that should be considered when calculating net income. Actually, one of the things I have always disliked about shares given to officers is that it seems to be a way to pay them ‘sneakily’, i.e., without accounting for a cost to the company, despite it being very much a cost.

Hi lemur, Yes it does annoy us. They are paying the officers sneakily, at our expense, and not at the company’s expense. But that’s what I’m saying. Just because it is irritating doesn’t mean it reduces Net Income by a penny. GAAP wants to punish them for being “bad boys” and forces them to make believe that it costs the company. But it doesn’t cost the company anything. Net Income doesn’t care how many shares are out. A stock grant just costs us stockholders by diluting OUR shares and makes them a smaller part of the total pie. But it doesn’t cost the company anything. It’s free, to them.

Saul

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That’s true, but the effect on the shareholders is the same. Whether we, as shareholders, pay the CEO through dilution of our ownership or through cash held by the company, it’s still affecting our share of the earnings.

That’s very true. We pay through dilution of our shares. GAAP tries to make believe there is reduced net income TOO! (Which is obviously false on the face of it).

Saul

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While not reducing the company’s overall net income, awarding stock to officers certainly dilutes the ownership of the other shareholders wrt that income. This dilution is multiplied further if a company awards officers deep in the money options. In this case the directors (who should be watching out for shareholders interests) are selling ownership of that earned net income for pennies on the dollar, while minimizing the risk associated with owning stock.

DT

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If you have to pay an executive $1 million in order to get the quality of person you need, how is that not part of the cost of doing business?

Why can’t we establish some form of accounting principle that expresses that? Net operating profit can be unaffected but liabilities increase on the balance sheet?

If everything was paid in stock, revenue would equal profit and you would never be able to figure out how the company was really doing.

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The issue though Saul, is when someone is issued SBC as part of their pay, rather than a bonus for going above and beyond or whatever, it hides the true cost of the company to do business.

Suppose Executive A gets $1mil a year for his salary. His company makes $0 in net income, no EPS at all. If the company pays him just $250,000 in cash, and awards him $750,000 in SBC, the company just earned an extra $750,000 in net income. Even if the company records $750,000 in profit, the actual cost of doing business negates that amount. They are just using shareholder money through share dilution for SBC to cover payroll costs. When they’re able to record higher net income, while EPS either stays the same (or in some cases actually increases), you are exaggerating the margins of a company because of this.

Personally, I think GAAP and non-GAAP are due for a complete overhaul of how the accounting practices work, to better reflect how a company is performing.

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But, the stock issued is reported, so you know exactly how much and under what terms. The issue is simply whether it belongs in the expenses on the P&L. Since there is no actual expense, why should it be there?

The idea of a company being able to pay all their expenses in stock is fictitious, so why dwell on it? It would be an interesting company if it did exist … a combination of the worst case of dilution that one could imagine with a company so impressive that everyone was willing to take stock instead of cash.

Since there is no actual expense, why should it be there?

This is the crux of the issue, and I really wish both sides would recognize it, so we could move on. There’s really no disagreement here in whether or not this is a cost: it is. And we all agree the shareholders are the ones paying it.

The question is this: when a company looks more profitable because the shareholders are paying some of its costs, is that reasonable?

If I ran a lemonade stand and spent more on lemons and sugar than I charged customers for the finished product, but paid for it with my dad’s credit card, I would look profitable. But would you want to invest in my business? No.

Sure, that’s an extreme case. But the principle is the same. Any costs the shareholders pay makes the company look more profitable than it would otherwise be.

However, this is offset by share dilution, so it’s not unaccounted for.

But it can be misleading, as in the lemonade stand example.

Bear

However, this is offset by share dilution, so it’s not unaccounted for.

I suggest this is a key point. To understand how a business is doing, one needs to look at the financials for more than just a few numbers. Was there a big inflow of money that doesn’t relate to on-going business? Or a non-recurring expense? Or does that “non-recurring” expense somehow recur every quarter? Is an inventory buildup a sign of lots of revenue in the pipeline or of sales not happening like expected?

The stock grants are there to examine. You are free to make your judgement about whether they are excessive or appropriate … just as you can make similar judgement about the cash part of executive compensation. No one is hiding anything.

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GAAP wants to punish them for being “bad boys” and forces them to make believe that it costs the company.

Saul,

Perhaps in this case the purpose of GAAP is to represent the interests of shareholders and not to have a perfect reflection on the performance of a narrow definition of the “company”. To the extent that the purpose of a company is to reward debt holders and share holders (which I disagree with to some extent, but don’t want to get into a political debate here), then I believe that there are definitely times when it’s more important to understand the effect on shareholders than the effect on “the company”, especially when management is playing around with things like share and option grants.

JMHO

as always, i am full of carp

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GAAP wants to punish them for being “bad boys” and forces them to make believe that it costs the company.

Saul, Perhaps in this case the purpose of GAAP is to represent the interests of shareholders and not to have a perfect reflection on the performance of a narrow definition of the “company”.

Hi, Full of carp! I certainly agree it would be nice. I guess I feel that the additional shares, and reduced EPS that results, does that, but making believe that Net Income is reduced is just make believe.

But look, everyone has the right to their own opinion.

Saul

I guess I feel that the additional shares, and reduced EPS that results, does that, but making believe that Net Income is reduced is just make believe.

Making believe that the company can have a higher Net Income by partially paying employees through share dilution is just make believe too. The actual cost for the company to do business, regardless of who takes up the burden of that cost, is higher than what they are reporting.

Let’s say an employee gets some restricted stock, which is basically stock that they cannot sell for 3-4 years, and is pro-rated over that time period. The company gets a sizable tax deduction when that stock vests. If the company buys back the shares from the employee after that time period, the expense of doing so does not impact free cash flow. How is this even remotely fair, to compare one company’s FCF that is high in SBC to another that is low in SBC? Both companies could have the same amount of revenue and the same cost of doing business, but the one that is higher in SBC has higher net income, higher margins, higher FCF - how is that not cooking the books?

Sure, EPS is affected by share dilution, but there are some cases where EPS can actually be slightly higher over the long term while using a heavy SBC approach, depending on options exercise time-frames and the company’s actual net income.

Where GAAP has an issue is the double-hit on reporting, where EPS is reduced through share dilution, Net Income is reduced by factoring in SBC. There is also a third hit with the impact on FCF from SBC repurchases if using GAAP. The thing I like about non-GAAP is that it largely ignores big one-time expenses are tax breaks that aren’t going to be repeated, and can skew results.

I am of the opinion that non-GAAP should use the following guidelines:

Revenue stays as is, no impact.

EPS should use net income divided by the total outstanding share count. Avoid the double hit by using Net Income without the SBC subtracted for this calculation.

Reported Net Income should subtract SBC - it is an expense of doing business, regardless of who pays it.

Reported Free Cash Flow should subtract any repurchases the company has made of employee restricted stock or options.

Reported Margins should include the cost of SBC. Saying a company has a 34% Profit Margin, when a percentage of that is because of shareholders taking on the burden of paying employees, is completely deceptive.

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I am of the opinion that non-GAAP should use the following guidelines:

Revenue stays as is, no impact.

EPS should use net income divided by the total outstanding share count. Avoid the double hit by using Net Income without the SBC subtracted for this calculation.

Reported Net Income should subtract SBC - it is an expense of doing business, regardless of who pays it.

Reported Free Cash Flow should subtract any repurchases the company has made of employee restricted stock or options.

Reported Margins should include the cost of SBC. Saying a company has a 34% Profit Margin, when a percentage of that is because of shareholders taking on the burden of paying employees, is completely deceptive.

Hi Welgard, Very interesting set of proposals! It sounds complicated at first but people could get used to it. My biggest gripe is also the double hit.

Saul

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My biggest gripe is also the double hit.

For me it helps to think about what GAAP is and what it isn’t.

First, GAAP serves different audiences. We naturally tend to view the center of the universe as being us equity investors, but the primary objective of GAAP is not equity valuation. Because GAAP stakeholders also include lenders, vendors, auditors, regulators, and policy makers, GAAP has to meet other needs. For example, while diluted EPS may be a key measure for us, it plays a minor role for a lender. These stakeholders are more interested in the economic and risk impact of options and NOT their impact on equity valuation. What seems like nonsense to us may be critical for these other stakeholders, and vice-versa!

Second, GAAP is a set of standards that ensures that all companies use the same methods for financial reporting. The emphasis is on control and enforcement rather than equity valuation.

Bottom Line: GAAP serves a much broader purpose than just valuing a stock. So we need come up with our own ways to build on the information that GAAP gives us. If you think stock based compensation should be removed from the income statement, go for it! I do this type of thing all the time. For example, if a company spends heavily on advertising, I might revise the GAAP income statement to treat that as a capital expenditure and amortize it over time rather than fully expense it in the current period. Let’s stop picking on GAAP – it’s there to protect us!

Ears

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